Cisco: Secure 3.5% Yield With Big Room To Grow

Summary

• Cisco Systems designs, manufactures and sells IP-based network solutions, products, and related services, which are at the heart of the growing IoT revolution.
• Cisco operates in a somewhat mature market, but the launch of 5G networks and Cisco's change in business strategy with "Silicon One" could reignite growth.
• Even with slow or no real revenue growth, Cisco continues to generate robust free cash flow, which will allow dividends and buybacks to continue to rise.
• Cisco is grossly undervalued after the sell-off in March. I rate Cisco as a conviction buy at the current price of $41 for DG investors.
• Looking for more stock ideas like this one? Get them exclusively at Beating the Market. Get started today »

Source: www.futurumresearch.net

Investment Thesis

After the recent sell-off (to put it lightly), Cisco (NASDAQ:CSCO) has come to trade at a level where long-term dividend investors can add it to their portfolios with conviction. At $41 a share (and a 3.45% dividend yield), Cisco’s stock is grossly undervalued, as I will demonstrate later in this article.

Since Cisco is seen as something of a bellwether for global economic trends, it's justifiably being substantially discounted; however, the pessimism priced into the stock is excessive and has created an opportunity to generate solid returns. However, to be clear, I don't view these returns as blockbuster by any means, but they're rather secure. Further, the company yields a solid 3.45% dividend, and I am all about catering to dividend growth investors as much as I am about catering to high growth investors.

To be sure, Cisco’s revenue growth is projected to be underwhelming yet again; however, there's hope yet on the horizon! I've predicated my investment thesis contained herein on a few factors:

• 5G technology’s official arrival (which will entail an uptick in routing & switching device demand),
• Cisco’s network disaggregation (hardware and software independence), and
• Adoption of a subscription model for its software & services.

Even with insignificant growth over the last decade, Cisco has managed to enhance shareholder value via stable, rising dividends (9 years running heretofore) and stock buybacks. Cisco’s market leadership and financial strength should enable it to continue in this vein for the foreseeable future.

To put it concisely, I view Cisco as a fantastic opportunity for investors who strive for a robust, consistently growing dividend income (from the first day of purchase) with the potential for long-term price appreciation.

Outline of Today's Research Note

1. Cisco: Business Overview
2. A look into Cisco’s financials
3. Estimation of a fair value for Cisco’s stock
4. Final recommendation on Cisco

Let's get started!

Cisco: Business Overview

Cisco Systems touts itself as the worldwide leader in IT, networking, and cybersecurity solutions. The company’s core business comprises the design and manufacturing of networking hardware, related software solutions, IT services, and cybersecurity. Despite the immense expansion of SaaS (software as a service) and the development of cloud computing, Cisco’s major revenue source is still largely its legacy hardware (routing and switches) unit that contributes to ~75% of its total revenues.

Source: TelecomLead

As can be seen in the chart above, Cisco commands nearly ~48% market share of the worldwide routing and switches market, the growth of which is not incredible, but still steady. With the advent of 5G technology and augmented reality more broadly, the number of connected IoT devices across the globe is set to explode. According to Statista.com, there were 26.66 billion connected IoT devices across the globe in 2019, and this figure is set to rise to 75.44 billion by 2025!

For all these devices to communicate with one another (which is the central idea of the Internet of Things), the need for network equipment is going to balloon. The expected growth for routing and switches market is 7% CAGR between 2019 and 2023. Cisco envisions using 5G’s capability (low latency - 1GB/s) to replace legacy wired access networks (WAN). Such an application of 5G could revolutionize business and residential wired internet services. Also, data centers will require new technologies like 400G to tackle the impending data boom.

For those of you with Dotcom bubble PTSD, yes, Cisco is yet again on the precipice of capitalizing massive new developments in the way humans exist... But this time, the company does not trade at 40x sales. Instead, it trades at about 3.4x sales, a significantly more reasonable valuation.

Source: statista.com

Cisco's Disco With 5G (And Other Growth Catalysts)

Cisco is at the forefront of 5G innovation among network equipment manufacturers, and it is expected to win the majority of the market share in North America. Cisco will face stiff competition from Huawei, but there's such a massive market for Cisco and Huawei's products that they will both be able to eat. Thus, 5G could be a huge catalyst for accelerated growth at Cisco. Further, WiFi 6 (new WiFi internet standard) and 400G (data center) are other potential growth drivers in play at Cisco.

As I mentioned earlier, the network equipment market is mature, and growth rates are in the mid-single digits. Cisco understands this, and in response, the company has taken action to diversify its revenue stream away from its legacy hardware offerings. We will explore this in more detail when we study its revenue trends in the next section.

Cisco’s acquisition of companies like Jabber, OpenDNS, Jasper, and Webex has enabled the company to become a specialist in specific technology markets, such as the Internet of Things (IoT), energy management, and domain security.

With this foundational knowledge of Cisco’s present business in mind, let's now dig into its financials. In doing so, we will answer two questions:

1. Is Cisco under or overvalued?
2. What should we expect in the way of future returns from purchasing Cisco today?

A Look Into Cisco’s Financials

Before analyzing the income statement, I'd like to share Cisco’s price chart with you. Cisco has delivered price returns of only 4.8% CAGR over the last ten years, making it a significant underperformer in comparison to the S&P 500.

Source: YCharts

Now, you might be thinking, if Cisco is such an underperforming stock, then why is it being recommended as a buy? Valid question. A detailed financial statement analysis, in combination with vital information on potential growth drivers, provides us the answer to your question.

Income Statement Analysis

By this point in the analysis, I usually diverge into strictly numbers, but Cisco's income statement must be annotated, as after we just discussed its massive market opportunities, it's difficult to reconcile flattening revenues with massive market opportunities... So let's check it out.

Source: YCharts

As can be seen above, Cisco sports gross margins of 64%. Higher gross margins indicate that Cisco’s products and services are differentiated and highly valued by its customers. Companies that sell products with extremely low gross margins, such as Exxon Mobil (XOM) or Chipotle (CMG), produce products in markets that have low barriers to entry, and therefore, these companies cannot command pricing power. Cisco's margins demonstrate that, despite rampant competition in its sector, it remains one of the stalwart leaders in the industry.

Gross margins have gone up in the last five years, which is positive, but on the other hand, revenue has flattened. Such a pattern is not a great sign for the business and indicates something is hindering the company’s growth (spoiler alert: it's managerial execution).

Upon further investigation, I discovered that Cisco has been losing market share across the board due to some of its significant customers like AT&T (T) choosing more affordable generic “white-box” routers and switches for its network.

Traditional companies still depend on Cisco’s products, but disruptive cloud titans like Facebook (FB) strongly advocate disaggregation of networks (i.e., hardware and software are independent). Up until 2018, Cisco used to package its hardware and software offerings (upselling), and this unwanted dependency led to losses in market share to its more flexible rivals like Arista (ANET), Juniper (JNPR), and Huawei.

So, what has management done to address these issues borne out by the income statement? For a start, Cisco’s management opted to modify its business strategy. The company is now implementing a plan to disaggregate dependencies of its hardware on proprietary software (e.g., “Cisco Silicon One”).

Cisco Pulls the Covers off its $1 Billion New "Silicon One" Chip Architecture

Simultaneously, Cisco has been preparing for the future by reinvesting a considerable chunk of its cash flows into R&D, which it projects will embolden its software and services offerings. The results of such a strategy can be seen below:

Source: Cisco 10-K

In 2019, while revenue from infrastructure platforms went up 7%, applications and security revenues rose by 15% and 16%, respectively. The higher rate of growth in non-core segments proves that Cisco’s diversification plan is working. Cisco has also been transforming its business strategy within the software, moving from perpetual to subscription revenues. In Q2 FY 2020, the revenue from subscriptions constituted 72% of the total software revenues.

Source: Cisco.com

With 5G devices and networks going live, Cisco’s significant investments in 5G may bear fruits shortly, in the form of increased revenues. Additionally, worldwide growth in IoT devices and increased focus on cybersecurity should serve as a critical driver of revenues going forward. Cisco is well-positioned to take advantage of these major technology trends, and the company should see accelerated revenue growth (i.e., mid to high single digits) over the next few years.

Balance Sheet and Cash Flow Analysis

Cisco is a conservatively managed company, as is evidenced by its balance sheet, the long-term debt of which declined by 6 billion dollars from 2018 to 2019.

Rising Dividends and Stock Buybacks

Cisco has massive leverage to enhance shareholder returns through the return of capital. Though I have serious apprehensions about management's ability to execute (due to IBM (IBM) PTSD, though I never owned IBM, and my current growing concern regarding Alphabet (GOOG) (GOOGL)), Cisco has been extremely shareholder-friendly.

In the last few years, Cisco repurchased around $50B worth of shares outstanding, which has reduced its massive cash reserves on the balance sheet. As of today, those buybacks have proven to have been extraordinarily ill-timed, but that's only positive for us. Any manager who thought they were going to max out their bonuses via buybacks will now have to work doubly hard, and continue to buy back shares.

Source: YCharts

Cisco started paying dividends in 2011; since then, the annual dividend per share has steadily increased from $0.12 to $1.36. In the same time frame, through large buyback programs, the company reduced its number of shares outstanding by ~20% from 5.563 billion to 4.453 billion. Cisco’s strong cash flow generation and balance sheet should enable it to continue growing its dividends in the short and long term.

Source: YCharts

Even in a recessionary environment, I fully expect Cisco to continue paying, as even in a worst case scenario of 30% or 40% revenue declines, the dividend will be very safe.

What Should I Pay For Cisco?

To find a fair value for Cisco’s stock as well as the returns one should expect from buying it, we will employ my proprietary valuation model. Here’s what it entails:

1. Traditional discounted cash flow model using free cash flow to equity discounted by our (as shareholders) cost of capital.
2. Discounted cash flow model including the effects of buybacks.
3. Normalizing valuation for future growth prospects at the end of the ten years. (3a.) Then, using today’s share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.

Now, let’s check out the results.

L.A. Stevens Valuation Model

The L.A. Stevens Valuation Model answers two questions:

1. Is the company under or overvalued?
2. What should I expect in the way of future returns?

Assumptions:

Assumption	Value
Free cash flow per share	$3.25
Free cash flow per share growth rate	8%
Terminal growth rate	2%
Years of elevated growth	10
Total years to stimulate	100
Discount Rate (Our “Next Best Alternative”)	9.8%

Click to enlarge

Using the L.A. Stevens Valuation Model, I determined that Cisco’s fair value is $65.69, i.e., the stock is currently “Undervalued” by 37.58%.

Source: L.A. Stevens Valuation Model

The expected CAGR on investment in Cisco for ten years at the current price of $41 is 9.89%, which is equivalent to our hurdle rate (9.8%, i.e., 90-year annualized return on S&P 500). But a 3.45% dividend yield increases the total return to approximately ~13.3% CAGR, which will actually grow even larger as the dividend continues to grow via modest organic growth from revenues and through share repurchases.

Expected Returns

So you will find DCF calculations all over the internet and in many other articles here on Seeking Alpha, but those calculations do not define specifically where the share price will move, and as a result, what we can expect in the way of future returns from share price appreciation.

The L.A. Stevens Valuation Model streamlines the process of calculating share price appreciation (and ultimately determining expected returns) by automatically calculating current and future share prices based on the growth of free cash flow per share (which is what ultimately will drive a stock's price).

Here's the result:

Source: L.A. Stevens Valuation Model

• Therefore, if one were to buy at today’s price of $41, they should expect an annualized total return of about 13.3%, which is above our “hurdle rate,” which is our “next best alternative,” i.e., the 90-year annualized performance of SPY (9.8%).

Hence, I feel confident in recommending Cisco to long-term dividend investors at today’s price of $41, as this is a grossly undervalued stock with rock-solid dividends and potential for capital appreciation.

Final Recommendation

Cisco is a relatively high-tech company with rising dividends. We see revenues growing in mid to high single digits over the next five years due to a rise in global demand of Internet of Things (IoT) and 5G devices. With management’s continued motivation to return excess cash to shareholders, an investor can expect enhanced long-term returns. Moreover, the stock is highly undervalued at the current price. Thus, I recommend our readers looking for long-term dividend investments, with a potential for capital appreciation, to buy Cisco.

Key takeaway: “Buy” - Cisco Systems at $41.

Please feel free to provide your feedback in the comments section and share your thoughts on Cisco Systems!

As always, thanks for reading; remember to follow, and happy investing!

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Algorithmic]

@Louis Stevens nice article. You mentioned that you liked posts that give you an insiders perspective on CSCO.

During the growth years, CSCO bought most of its technology and paid for it in CSCO stock. My brother and I have owned it since 1997. What this means is that the dilution was massive, the shelf of sellers was huge (because they were ex-owners) and that is one of the reasons the stock has been a laggard since dot-com.

The culture is a top 80, like Oracle, meaning the bottom 20% of sales reps, don't survive the year. A juggernaut sales mentality.

The shift to subscription based services. The computer industry is making this shift, especially towards maintenance. In CSCO's case, their EULA agreements, only go in one direction, UP. This means that over time, unless the buyer is very, very careful, they end of paying for maintenance they don't need. Very profitable. Last time I saw their 10-K, 30% of Sales was maintenance.

What did Larry Ellison say? "Maintenance is where great technology companies go to die." Here is hoping for a good Quarter. I re-established a position in March 2020.

[Louis Stevens]

@Algorithmic

So I think we're in the same camp here.

It's taken almost two decades for the company to recover from the culture and irrational exuberance that was created during the dotcom bubble.

This next decade may be its renaissance in terms of SPY outperformance, solely because the company has gotten so cheap and untrusted (in terms of generating Alpha).

[European investor 99]

I love Cisco, I think they are well positioned on a long term, just dont understand why they cant break out of this low 40s range since March. There are other competitors on the market who are already doubled or went significantly higher while CSCO still sits the same spot +-5% sideways. I added some recently and waiting for earnings. IF goes up I am happy I hold it, if goes down I will buy in more for long term hold.

[Louis Stevens]

@Stock nomad

What's your objective here?

Safe yield that can grow or to outperform an index fund? Or a mixture of both?

[European investor 99]

@Louis Stevens thanks for asking. I think a bit of both, but I expect that they are becoming stronger due to COVID long term effect. After all it is a network, Security, internet, videoconferencing....etc. company. Might not be as innovative as ZM or ZS, but they are a giant with the cash and big corporate market contracts with reliability and safety. It is more important for large(or small) businesses than fancy user interface.
Who can benefit from this as tech company if not them and the rest (MSFT, Chipmakers...etc.) + of course the obvious home streaming/delivery/pharma industries? I rather put my money into a diverse reliable Cisco than overhyped Zoom or Zscaler with one single fancy product.

[Louis Stevens]

@Stock nomad

Of course, you'd/we'd not want to buy ZM at $170.

But wouldn't you want to buy it at $70 where we originally bought it?

It's all about identifying value and acting accordingly.

CSCO is an extremely low-risk investment and investors will be compensated accordingly.

[Dividend Latitude]

Thank you for a nice article on CSCO, Louis

[LazyGringo]

As you can see, there is one sector which is not really hurt by Covid 19 and quarantines, and that is the internet. CSCO is a backbone of the internet stock. AAPL is the dominant platform, hardware and services internet stock. T and VZ are the broadband providers. And VIAC is my pick as bargain basement double or triple candidate now and also supply home entertainment as do T and Apple. All of these stocks pay dividends and keep the income rolling in. All of them are more or less undervalued and all will survive Covid 19 quite nicely. I own all of them too as a disclaimer and am bullish on them all. I would own Amazon, Google, Facebook and Netflix too but prefer dividend stocks and they and Microsoft seem more or less too richly valued for my taste. Also, 5G will benefit all of these stocks that I own, some of them greatly, and 5G is now coming very soon.

[Prince_0f_Uranus]

you should also consider Qualcomm, if you like dividend paying companies that are set to benefit from 5g

[Louis Stevens]

@Prince_0f_Uranus @LazyGringo

Qualcomm, broadcom, Cisco...

We discuss all of these in our marketplace service.

We offer them as alternatives to yield seekers who have historically bought oil.

Try us out for free: seekingalpha.com/...

[Vandooman]

Good article. Another way of looking at buy backs. Management loves them because of tax matters but more so because a dividend cut has serious implications while on the surface cancelling buy backs does not. So to raise a dividend you have to have confidence that it is sustainable. That gives me more confidence in the future than a buy back. I also have financed many a takeover where a goodly part of the price paid was from cash on the acquired company's balance sheet. That is another big reason for buy backs, to rid themselves of the cash that could make them a target. Finance your own takeover and the CEO and CFO get fired.

Buy backs can increase EPS but a dividend increase means management has confidence in the future. An increase in EPS does not automatically translate into a share price increase because the PE ratio may decrease. A series of dividend increases can be more effective. And any advantage from buy backs can collapse if you cancel them. I don't hate buy backs but there is more to them than the math. Investor sentiment counts.

[LazyGringo]

Here is my non-technical hunch feeling analysis of CSCO. At 41 it is kind of a no-brainer buy, still near its bottom, which seems to be around 37 on a bad selloff day, therefore the downside is minimal, And any slowdown or lost market share news is more than priced in. Plus I understand that all their customers who have put off spending in the last year or so must spend that money for big upgrades soon, so lost profits from 2019-20 are simply being pushed into 2021-2022. I see they are offering customers attractive credit too, like down 5% now and owe them 95%. Kind of like buying a car or an iPhone if you use a 36 month plan. And this crisis and if this shutdown has proven one thing is that the world needs more bandwidth, more internet, more steaming HD, more expansion of internet services and then 5G makes upgrades mandatory for everyone. So CSCO is in a sweet spot and I assume they are smart enough to execute and learn from any past mistakes. So yes this is a BUY now at 41 fro sure as they should be able to return to last year's high at least in the next 18 months, and that is about a 25% profit from here, plus you get a dividend as high or higher than anything you can safely get from bonds. and CSCO is a safe company with a safe dividend and these days that counts for a lot. That is why I have 95% of my money in four stocks; mostly AAPl, then CSCO, T and VZ, with the knowledge that these days especially the internet is king. In fact internet useage during the crisis is up around 100%.

[Naked Stranger]

I'm a retired IT network engineer for a large hospital. We were a Cisco shop for almost 20 years. But tight budgets started to force management to look for cheaper alternatives. I personally am still a big fan of Cisco gear. But that didn't stop management from moving to Juniper and Palo Alto to save a considerable amount of money, both on the front end purchase and the long term maintenance.
Cisco has been pricing itself out of the market by changing their model from a seller of hardware to a seller of software and software licensing.
From a purchase standpoint, I hated that new model, it made it harder for us to purchase.
From a Cisco revenue perspective, it was the right move, it just could have been done much better.
I own some Cisco stock still, and will add to my position if the price drops down to the mid 30's again.

[Louis Stevens]

@Naked Stranger

Awesome account of your personal experience!

Love these types of comments.

[Chris Valley]

It is also interesting about palo alto networks- they have the highest average wage of any tech company. So that's a good combination, with the affordability.

Selling Jun 39/45-46 ratio short strangles in Cisco.

[Technosemi]

We'd heard this same story over and over again, ad nauseum. "Big room to grow." Yeah, after looking at its plummet late Feb. to early April.

Not a stock to put your faith and money in.

[Louis Stevens]

@Technosemi

At 50, I wouldn't have recommended it. At 60, I wouldn't have recommended it.

At 40, it's more compelling...

[valleyside]

Where have you been the past couple of months? Most stocks plummeted from late February to April.

[kos47]

The last time I bought Cisco was on 3/12/20 for $34.56. I will buy it again at ~36.00 and not more. If I miss the opportunity of a lifetime to buy it at the current price of ~$41.00 so be it, it’s not the first time and it won’t be the last.

[Allinvestor]

A lot depends on that 8% FCF growth you are assuming. What did you base that on?

[Louis Stevens]

@Allinvestor

Hey thanks for the question,

So they've grown their fcf per share at 11% over the last 5 years with anemic growth.

They will be able to sustain 5% annualized free cash flow per share growth by simply buying back 25% of their float over the next 10 years (extremely doable).

So management needs to literally muster 3% average annualized growth over the next 10 years in an industry growing at 7% CAGR...

If management can't achieve that, then the whole board and c-suite will need to be wiped out.

[Allinvestor]

Thanks for elaborating - I agree with you on that. Long CSCO by the way, but will be closely monitoring their deteriorating market share vs. the likes of ANET as growth has been sub-par in the past couple of years and these market dynamics could be concerning long-term.

[Buyandhold 2012]

Louis,

Does it concern you that the 5 year expected PEG ratio of Cisco is 2.52?

[Louis Stevens]

@Buyandhold 2012

Hi friend,

I don't use PEG too much. Just mostly calculate out where FCF per share will be by 2030, then use a conservative P/FCF to arrive at a target price.

Then use the current price and target price to arrive at a CAGR.

Very straightforward and the whole process is coded into my website

[Buyandhold 2012]

Louis,

Thank you for your reply.

Free cash flow has been getting a lot of attention lately.

I'll start to pay more attention to it.

[Chris Valley]

[Most of your holdings in the lower yielding stocks tend to have a high free cash flow and lower debt as well.]

[Harleythor]

It seems like this analysis was written before the Pandemic. The world has changed since.
Most of the world is now in a depression, a quarter million dead, high unemployment.
If Cisco is to hold its 3.5% dividend it better take out a loan at these Zero rates and buy back a massive amount of shares.
Hauwei will not be as big a factor since I see Nokia and Erickson getting together on 5G. Besides Cisco has no radio to do 5G, only thing Cisco can do is backbone, security, you either
have radios or you don't have 5G.
The Chinese have lost good will, with how they lied about the pandemic not being human to human. China horded the Protective equipment, and sold faulty protective gear, faulty respirators and ventillators, and masks. China tried to foreclose on poor African countries.
They hid the truth, lied, and refused to let the world scientist in to study the virus.
I don't think their spyware laden gear will be in too many networks. A a former Telecomm manager I would never by spyware gear from known liars.

[jvelez12]

Cisco makes stuff related go computers and internet. there are more computers and more internet everyday so Cisco will continue to grow.

[Louis Stevens]

@jvelez12

I mean it should!

We'll see if management can take advantage of the massive opportunities before it.

[Dividend Ambassador]

CSCO is a great great company and it is one of my largest holdings out of about 70 different positions. However, one must be patient w purchases of CSCO. CSCO is a company that the market periodically likes to hate. It is often available (if your timeframe is years not months) at significant discounts to fair value. If you are patient you can certainly buy CSCO even cheaper than CSCO currently sells for. My rule of thumb is to ONLY buy CSCO when yield is at or above 4%. It has served me very well.